You and potential buyers can be at loggerheads when it comes to whether you sell stock or assets

When you decide to sell your business, legal and tax considerations can loom large -- for both you and your buyer. Matters can get complicated pretty quickly. Peter DeMarco, director of tax services for Meaden & Moore, a Cleveland-based accounting firm that frequently advises owners on the ins and outs of selling their companies, explains: "People come in and say, 'I want to get $1 million for my company.' So we ask them, 'Well, what do you want to sell, the stock or the assets?' They tell us, 'I don't know. Does it really matter? I never thought about it before.' And then we explain to them how much their after-tax payoff really depends on the exact structure of what's being sold. Depending on what kind of deal they do, that $1 million may be achievable or completely unrealistic."

When you started your business, you may not have considered how the corporate form you chose would affect selling the company later on. Instead, whether you chose to establish an S corporation or a C corporation probably depended on your long-term financing strategies as well as a variety of legal and tax considerations. And when it comes to issues like those, every situation is unique.

With the S corporation there's a tax advantage, since income and losses pass directly through to the owners and thus avoid the double taxation of C corporations. But the rules limiting the number of shareholders make the S structure unwieldy for companies that plan to bring in professional investors or go public one day. The advantage of C corporations is that they permit any number of shareholders. Income, however, is taxed twice, first at the corporate level and then individually when it is paid out to the owners either in compensation or in stock dividends.

On the legal side, sellers of C corporations and S corporations may be indifferent to whether the deal involves stock or assets, whereas buyers typically prefer an asset-based transaction. (Assets include hard assets -- real estate, computer equipment, furniture, machinery, and the like -- as well as intangibles, such as intellectual property, client lists, and so-called goodwill.) Buyers prefer asset-based deals, DeMarco says, "because when you buy assets, nothing unwanted gets carried over from the original corporate entity. If you buy the company's stock, then you get all the disclosed, but also undisclosed, liabilities. People are afraid that there might be skeletons lurking in the closet, which might take the form of environmental liabilities, upcoming lawsuits, or even unpaid tax bills."

When it comes to tax considerations, it generally doesn't matter to sellers of S corporations whether the buyer pays for stock or assets. Peter J. Reilly, a partner at the Worcester, Mass., accounting firm Carlin, Charron & Rosen LLP, explains: "The gain passes directly to the owner, who then pays capital-gains tax on it." The S-corporation seller winds up with the same amount of cash either way.

The owners of C corporations, on the other hand, are far better off selling stock than selling assets. Consider this hypothetical situation: An entrepreneur -- and sole owner -- started her software consulting firm by making a $1,000 investment; she is now selling her company, which is structured as a C corporation, for $1 million. If she sells stock, she is making a personal trans- action, just as if she were selling shares of, say, IBM. The difference between her original investment and the sale price could be subject to a capital-gains tax of 20%. In this example, she would clear $799,000 after taxes from her com- pany's sale.

But if this owner structured a deal around the sale of assets, the after-tax outcome would be far less lucrative for her. That's because the C corporation, rather than the owner, would be selling the assets. The business itself would owe taxes on the deal, probably at a rate of about 35%. The owner would end up paying a personal capital-gains tax of about 20% on the remaining $650,000 and would wind up with $520,000.

However, tax pressures, in addition to legal concerns, encourage buyers to push for asset sales. Kris Karlson, president of Bowman/Hanson, an investment-banking firm in San Francisco, says, "If a buyer pays $1 million for an asset-based deal, then the IRS allows the buyer to start depreciating those assets immediately, which can provide a very valuable tax benefit." In contrast, when a deal is structured around stock, the assets on the books must be amortized at their value to the seller, which is likely to be far less than the total sale price. The negative aspect from a buyer's vantage point is that intangibles like goodwill can't be written off as quickly as they might be in an asset-based deal.

Clearly, S corporations are in the best position to keep their selling options open -- and their sales prices high. But switching from C-corporation status isn't much of an option, since Uncle Sam doesn't look with favor on that strategy. If you make the switch and then go on to sell your company anytime within 10 years, you'll basically be subject to the same tax treatment you would have faced in your original C-corporation status. (The financial penalty becomes less the longer you delay, but it takes 10 years to disappear.)

That means that owners of C corporations should try to be flexible about their price tag during a sale or should look for ways to make a stock-based deal work. Karlson says, "You can find buyers who won't care if they can't depreciate assets, maybe because they'll be taking on so much debt tied to the transaction that they don't need any more tax write-offs. Or your own company might carry with it other advantages, maybe in the form of a below-market lease or some other beneficial legal agreement, which could compensate." In such cases, the C-corporation seller should be prepared to sign legal documents that will indemnify the buyer against a range of liabilities. And then the seller should keep his or her fingers crossed.

Every once in a great while, the federal government acknowledges that it made a mistake. That's what happened in the case of the Tax Relief Extension Act of 1999, which jeopardized the ability of many small-company owners to sell their businesses in asset-based transactions.

Formerly, owners who sold their companies through asset sales and received the payment in installments had to pay taxes on an installment basis also. The 1999 act changed the rules so that owners who used the accrual method of accounting had to pay Uncle Sam the full tax bill on asset sales during the year in which a sale closed, no matter how long it took the buyer to pay up.

"There was a huge outcry," says Daniel Zucker, a partner at the Chicago law firm McDermott, Will & Emery. During the weeks before New Year's Day 2001, the statutory change was repealed on a retroactive basis and was reverted to the law as it stood before the act's effective date of December 17, 1999.